What is “Phantom Income” for a small business owner?

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Before I can define

“phantom income,” I’ve first got to explain how “tax flow through entities” work. Basically, if you own at least part of a partnership, limited liability company or S-corporation, you get a a tax bill each year based on your share of the business’ profits. That bill comes in the form of a K-1 tax form, which shows your portion of the profits or losses.

So, if you own 40% of a company (for the entire tax year) that had $100,000 of profits in 2008, then you would get a K-1 for $40,000. If you only owned that 40% for half the year, your K-1 should report $20,000 of imputed income to you. You then have to report that income on your individual income tax return and pay taxes on that amount.

But wait! What if the company never paid you a distribution (a/k/a dividend) equal to your K-1 number? Or, what if the company only pays you $12,000, but your K-1 shows $40,000 of income? If that happens, you have have “phantom income.” So, even though you only received a distribution of $12,000, you have to pay income taxes on the full $40,000.

If you want to avoid paying taxes on “phantom income,” then you should consider an agreement among all the owners and the company requiring the company to distribute at least enough profits to cover the taxes on your “phantom income. When I draft these agreements for my clients, I like to include a provision requiring no less than 40% of the company’s profits to be distributed, which should normally be enough in distributions to cover the highest marginal tax rate on any one owner. I include an exception, in the event the company has anticipated cash flow issues, or is about to make a large expenditure and needs the cash.

If you fail to include such a provision in your agreements, then you run the risk that the majority owners might try to “freeze out” the minority owners by causing “phantom income” to be reported on the minority owner’s K-1, year after year after year. In that case, it actually costs money for the minority owners to own a share of a profitable company.

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10 thoughts on “What is “Phantom Income” for a small business owner?

    • Paul-

      Thanks for the question, but I’m not sure I have enough facts to answer it. “Phantom income” references taxable income of a “tax flow through” entity that must be reported on the owners’ tax returns. A loan payment from an entity would not constitute income for the entity or its owners.

      Can you add more facts so that I can identify the issue?

      Thanks.

      Matt

  1. Matt –
    I have received shares of two separate Sub Chapter S Corps as part of an inheritance. It has been a very lengthy probate process and the court approved an early distribution of the shares to prevent negative tax consequences on the companies. (One company is a family owned business with each family member owning and equal 1/5 of the shares). Both companies have not been forth-coming with any company information and neither share-holder agreement includes any clauses regarding “phantom income” or the process of distributing dividends. What is my available recourse for obtaining the documents necessary to determine my tax liability and/or adding a clause in each share-holder agreement regarding dividends and phantom income when I am a minority share-holder?

    • Jessica-

      You probably should meet with a lawyer skilled in small company ownership structures. Family-owned businesses pose even more complications and require even more expertise.

      In most states, owners have the right to demand certain documents and data. State law governs, if the organizational documents do not address these issues. Start there.

      Without a clause in the organizational documents, you have to pursue a claim that the majority is trying to “freeze” you out. That’s a tough claim, but can be won. I hope for you that it’s easier to negotiate a “mandatory distribution” provision, which I often put in my organizational documents.

      Best of luck.

      Matt

  2. Matt,
    My wife’s real estate law office, an LLC, was repaying money loaned to the office, to keep it afloat, by her partner. The partner is her father as well. The money that has been repaid is being reported on her K1 as her income. Is this right? What a surprise! There seemed to be no planning or communication of future tax consequences when the money was loaned. Actually my wife raised questions in 2008, but was dismissed in a way and told everything was good.

    • Mark-

      I was a little confused by your fact pattern. So, let me try to restate the facts in this response.

      If the LLC borrowed money and then repaid that loan, the principal should not be reported on the K-1 of a member of the LLC. To the contrary, the interest, if any, paid by the LLC could be reported on a 1099 as interest paid to the lender.

      I think you should see a CPA, ASAP.

      -Matt

  3. Matt,

    I work for a manufactured home community developer in Michigan. For the past 4 years we have been forced to lend money (due to our economy and lack of available lending sources) as if we were a bank to people who want to purchase homes in our communities. The owners have become very annoyed with the fact that we have to spend so much money purchasing repossessed homes in our communities as well the cost of reconditioning them only to sell them with terms. What is really killing them is the fact of them having to pay taxes on “phantom profits”. What do you recommend or how can we restructure the company so that taxes only have to be paid as profits are being made? The company cannot handle another drain on it’s capital…

    Thanks,
    Brian

    • Brian-

      You shouldn’t be having phantom profit. There is a misunderstanding somewhere.

      I think a good business CPA could help explain your situation to you better or help you in finding a solution, assuming you even have a problem. The tax code is not applied as your question suggestions.

      Let’s regroup. Go get a good CPA in Michigan. If you’d like to talk to a CPA in Indiana, let me know. Email me at matt@indybizlaw.com.

      Thanks and best wishes.

      Matt

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